This publication provides an overview of the subscription finance security package in transactions involving Cayman Islands fund structures.
FUND STRUCTURES IN SUBSCRIPTION FACILITIES
Cayman Islands private equity funds have historically been registered as exempted limited partnerships (ELPs), particularly for the North American and European markets. While other types of Cayman entities (such as exempted companies and limited liability companies (LLCs)) are occasionally used as fund vehicles, the ELP is by far the most common type of entity used for closed-ended private equity funds. For this reason, this section primarily focuses on subscription facilities involving an ELP.
An ELP is not a separate legal entity; rather, it reflects a contractual agreement between the partners, where the general partner is vested with certain duties and powers with respect to the ELP's business and assets. Any rights and obligations of the general partner and the limited partners are therefore contractual in nature and will be governed by the provisions of the limited partnership agreement (LPA) and any subscription agreements (and/or side letters). The ELP's rights and property of every description, including all choses in action and any right to make capital calls and to receive the proceeds thereof, are held by the general partner in trust as an asset of the ELP.
TYPICAL SECURITY PACKAGE
The contractual obligation of a limited partner to fund capital, to the extent that it has not already been called (Uncalled Capital), and the corresponding rights of the ELP to call for Uncalled Capital (Capital Call Rights), together form the foundation of subscription facilities. Given that these rights (or choses in action) are contractual in nature, the appropriate form of Cayman Islands law security over such rights is an assignment by way of security.
The security over Capital Call Rights can be granted under a Cayman Islands law document, although the governing law of the security will generally depend on the market practice of the jurisdiction of the main transaction documents; for example, in facilities governed by English law, it is customary to enter into a separate Cayman Islands law security agreement creating security over such collateral, whereas it is unusual to take additional Cayman Islands law security in the US fund finance market, where facilities generally rely on security governed by the relevant US law. Assuming that the grant of security is permitted under the LPA, Cayman courts would generally recognise the grant of security even if such security were granted under a foreign law-governed security agreement.
The security package for subscription facilities also typically incorporates the grant of a security interest over a designated bank account under the control of the lender to which capital commitments are deposited; such security will typically be governed by the laws governing the bank account (e.g. US or English law). The applicable bank accounts are rarely located in the Cayman Islands, so it is fairly unusual to see Cayman account security in a subscription facility.
The security package will also be supported by an express irrevocable power of attorney in favour of the lender to exercise effectively the Capital Call Rights following the occurrence of an event of default.
Although not nearly as common as ELPs, we do occasionally see Cayman Islands exempted companies used as borrowers and/or feeders in subscription facilities, which gives rise to some additional considerations for a lender. In terms of the structural differences: while the governing agreement of an ELP is its LPA (which is a contract between the parties thereto with rights capable of assignment by the ELP), the governing agreement of a Cayman exempted company is its memorandum and articles of association (M&As), which are not of themselves capable of assignment by the company. This results in one of the fundamental differences in a corporate subscription facility, as a lender will essentially receive security over the subscription documents (which are then subject to the M&As), rather than over the actual governing document of the company. Unlike with ELPs, capital contributions are often linked to the obligation of the company to issue shares. Creation of an obligation on the investors in the company to purchase shares "to-be-issued" is different from the obligation of an investor in an ELP to fund the remainder of its capital commitment to the ELP as part of its existing interest and this difference can result in certain enforcement concerns, particularly on an insolvency of the company. As a result, additional care must be taken when structuring the security package for a subscription facility involving a Cayman exempted company.
PERFECTION FORMALITIES
Where a security interest is granted over Capital Call Rights set forth in a Cayman Islands law governed LPA, priority of the security interest as against any competing security interest will be determined in accordance with Cayman Islands law. This stipulates that where successive assignments of a chose in action are concerned, priority as between creditors is determined (based on the English court decision in Dearle v Hall (1828) 3 Russ 1) according to the order in which written notice of such assignment (Notice) is given to a third-party obligor (i.e. the limited partners of an ELP), so priority is not established in accordance with the time of creation of the relevant security interests. Perfection (by which we mean, in this instance, that security interests over the encumbered property will be enforceable as against third parties claiming to have a security interest in the same property) and priority over the Capital Call Rights, therefore, are achieved through the delivery of written Notice of the grant of security to the ELP's limited partners. Delay in the delivery of the Notice will therefore expose a lender to the risk that a subsequent competing security interest, or even an absolute assignment over Capital Call Rights, might be granted to another secured party. In such an instance, if notice of the second security interest is given to the investors ahead of notice of the first security interest, the subsequent secured party will rank for repayment ahead of the first secured party.
The Notice should include a clear description of the security document, including the identity of the secured party, and a description of the secured property (i.e. the Uncalled Capital and the Capital Call Rights). It is also prudent for the Notice to instruct investors where to make all payments with respect to Uncalled Capital as this prevents investors from obtaining good discharge for their obligations to fund their Uncalled Capital in any manner other than as specifically indicated in the Notice.
Given the significance of delivery of the Notice, evidence of the Notice having actually been received by investors also assumes some importance. Although ultimately a commercial and negotiated point as to what evidence a lender will require to get comfortable that an investor received a Notice, we usually recommend that the general partner of the ELP sign and deliver the Notices to the investors in accordance with the provisions of the LPA governing service of Notices on the investors, with proof of delivery provided to the lender.
If the bank account into which capital commitments are deposited is located in the Cayman Islands, priority of the security over such bank account is achieved by giving notice of the creation of the security interest to the applicable account bank. It is also market practice to require the account bank to provide a written acknowledgement of such notice.
While there is no public registry relating to the grant of capital call security in the Cayman Islands, Cayman Islands exempted companies and LLCs are required to enter particulars of all security created over their assets (wherever located) in a register of mortgages and charges (ROMC) maintained at their registered office. Importantly, the Cayman Islands statute does not aim to impose perfection requirements and failure to enter such particulars will not invalidate the security; however, Cayman Islands exempted companies and LLCs are expected to comply with the requirement, and failure to do so will expose such companies to a statutory penalty. While there is no corresponding requirement for an ELP to maintain an ROMC with respect to security over its assets, where the general partner of an ELP is a Cayman Islands exempted company or LLC, then (i) the general partner is required to update its ROMC with details of security granted in its own right, and (ii) it is advisable for the general partner (or, if applicable, an ultimate general partner) to update its ROMC with details of the security granted on behalf of the Cayman ELP. In practice, this puts any person inspecting the ROMC on notice as to the existence of the security.
ADDITIONAL CONSIDERATIONS FOR LENDERS – CAYMAN ISLANDS PRIVATE FUNDS ACT
The Private Funds Act, as amended (PF Act), came into force on 7 February 2020 and requires "private funds" to apply to be registered with the Cayman Islands Monetary Authority (CIMA) within 21 days after accepting capital commitments from investors. Significantly for subscription facilities, an in-scope private fund must be registered by CIMA before it accepts capital contributions for investments, which is of course of primary importance for the security package of a subscription facility (i.e. the ability to call for Uncalled Capital following an event of default). It is therefore crucial that any Cayman Islands private fund that is party to a subscription facility be registered with CIMA ahead of the initial closing or if applicable, its joinder to an existing facility. Given the substantial impact PF Act registration (or lack thereof) has on a lender's ability to enforce the security, the transaction documents for a subscription facility will also look to include various conditions precedent, covenants and events of default tied to registration under the PF Act.
First published in Praxio's Fund Finance Security Guide, 2024. You can download a copy of the full guide here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.